Illinois, the sovereign entity, gets a slap on the wrist

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Numerous public pension plans across America are in horrendous shape. The employee plan of the Commonwealth of Puerto Rico, funded at an alleged 7 percent of assets, is functionally broke. Other public plans, like that of Charleston, West Virginia, have 24 percent of the assets needed to meet future promises to retirees.

There is little to no regulatory oversight of public pensions. And what little there is comes in a roundabout way. For example, the sanction that the Securities and Exchange Commission administered to the state of Illinois for not adequately disclosing to bond investors that it was not properly funding its system.

The state omitted to disclose in preliminary and final official statements material information regarding the structural underfunding of its pension systems and the resulting risks to the state’s financial condition.

So the SEC says to a state, “You were not telling investors, who bought your bonds, all the facts.” And then essentially says, “Don’t do it again.” Of course, the SEC could have fined Illinois, but taxpayers would just foot the bill for this. There must have been dozens of people involved in the preparation of the state’s bond offering documents. Was there a mastermind behind it? Probably not. If there had been, the SEC would have charged that individual as it did in the case of San Diego officials who misrepresented the city’s pension. Those charges were eventually dismissed.

Now all the media is filled will howls of indignation at the SEC for the lame treatment of Illinois. This was capped with Bloomberg’s Jonathan Weil’s piece, “And the SEC Wonders Why Investors Think It’s Spineless.” This is not quite fair. There is some kind of a heist of pension assets taking place in Illinois, but neither the SEC nor any other federal agency has the power do anything about it. Here is why, from the SEC complaint:

Illinois possesses all powers, functions, rights, privileges, and immunities authorized by the United States Constitution, the Illinois Constitution, and the state’s laws, including the power to issue debt.

The Tenth Amendment (Amendment X) to the United States Constitution, which is part of the Bill of Rights, was ratified on December 15, 1791. The Tenth Amendment states the Constitution’s principle of federalism by providing that powers not granted to the federal government by the Constitution, nor prohibited to the States, are reserved to the States or the people.

If the State of Illinois wants to underfund its pension plan, that is a state matter. However, it is different when it crosses into federal territory, which it does in three areas: in representations to securities investors, federal tax issues and federal bankruptcy court.

The SEC did what it could with its weak tools on disclosure. But that was too little, too late. The reality is that there are often large gaps in the law. States and cities with their massive underfunding of pension plans is one of these spaces where the law provides little safety for taxpayers, retiree pensions or bond investors.

There is a piece of federal legislation, filed in the last session of Congress, which would provide more transparency to investors, retirees and taxpayers. H.R.567, the Public Employee Pension Transparency Act, sponsored by House Ways and Means subcommittee chairman Devin Nunes (R-Ca), would kick states and cities where it hurts most. Nunes’ bill would strip the federal tax exempt status from the bonds of any municipal entity if they don’t follow the federal disclosure requirements. Watch how fast states and cities would hop to disclose the status of their pension plans.

There are hard days ahead for many states and cities to meet their commitments to retirees, education, Medicaid and other services. But the first step toward reform is to publicly admit the problem. Then all the parties can argue over how to divide up the shrinking pie.

By the way, the Illinois Constitution mandates that bond investors are paid before anyone else. Taxpayers and retirees will be getting the raw end of this deal.

Author Profile

I’m Cate Long and I write about the retail fixed income markets including municipal bonds. My primary interest is creating tools and systems to help retail investors understand bond markets. I’ve worked for a number of years with industry standards organizations, regulators and Congress to help craft a more transparent and fair framework for investors to participate in the fixed income markets. I'm a guest contributor to Reuters.com. Any opinions expressed are mine alone.